The Chinese Crude Futures Market

In Summer 2015, the Chinese began to explore the possibility of the unthinkable: launching a new global crude oil futures market in a pitifully abysmal energy economy. The Shanghai International Energy Exchange (“INE”) circulated drafts of the contracts in September 2015, with guesses believing that as soon as October of that year, the new benchmark would premiere. October passed, as did November, December and January 2016, with no Chinese crude futures contracts. What happened to this possibility? Why did the INE back off of their plans to increase liquidity and competition in the market? This briefing will outline the hopes and downfalls of the potential futures market, followed by a discussion about its situation within the current energy industry.

A Quick Word on Futures

Crude futures are primarily traded on West Texas Intermediate (out of Cushing, OK) and Brent (out of London, UK). They are both traded in US dollars and in one thousand barrel increments (approximately 42,000 gallons). Futures are traded in order to capture value during volatile periods. They are also traded to guarantee sales for producers and inputs for refineries. These latter two groups are purchasing the physical products, simply months or even years in advance. For this reason, a physical market and delivery system must be in place for a futures exchange to occur. It is also worth noting that crude oil futures trading is a trillion-dollar industry, with other benchmarks coming from Dubai, Russia, OPEC, Mexico, Nigeria and Singapore. Below in Figure 1, there is a representation of where different crudes are traded, giving new meaning to “the sun never sets” on trading.

In December 2014, the Chinese Securities Regulatory Commission (“CSRC”), a government watchdog organization, approved INE’s application to host the contracts. The CSRC mandated at least three months of organizational time to set up appropriate guidelines and administrative rules for the futures, and to create the administrative structure for monitoring the trading. The CSRC also released a guideline for foreign traders and brokers to introduce them to the new market. This will be the first Chinese futures contract that will allow participation by foreign nationals, certainly a boon for economic liberalization in the country.

In a report from June 2015, Song Anping, the chairman of the Shanghai Futures Exchange (seen to the right), reportedly said the new trading platform would launch in September 2015. However, in September 2015, Forbes reported a potential launch in October 2015. The Chinese had not finished clearing out the state-owned oil majors, and these companies were slowing the progress. In order for the physical futures market to succeed, independent refiners needed access to the oil imports, and creating competition hurt PetroChina, Sinopec and China National Offshore Oil Corporation (CNOOC). As of September 2015, 11% of oil imports were going to independent refiners – 715,800 barrels away from state-owned refineries. The INE pushed liberalization of the market, a slow going process in the communist country. International investment firms were wary of the effects on the share prices for the majors, and the queue of independent refiners was growing.

The Hold Up

In November 2015, INE announced that it was further delaying the launch date, citing that all of the logistical and structural preparations were not complete. However, many analysts surmised that the near 30% drop in the Chinese stock market over the summer might have cut down interest in the project. This, coupled with rampant government control of the economy to curtail the negative effects of the drop, would have given the platform hosts some serious hesitation.

Additionally, the new contracts will be priced in Chinese yuan rather than US dollars, which will likely dampen foreign enthusiasm to participate in the market. It would increase trading risks and decrease the number of participants. Citigroup believes the new market will see primarily domestic participants. Adding this exchange risk to the negatively volatile market risks in the current Chinese and Energy industry markets makes the new contract a tough sell for foreign investment.

Within the Industry Context

To combat expected low interest, the Chinese will be trading in one hundred barrel increments, rather than the standard one thousand. This should attract boutique and retail investors internationally who are slow to invest $40,000 US on one contract. If oil prices remain low or drop, this would only fan the flames of investment. Many current traders look at the sideways market as an opportunity to get low futures prices far down the road. However, when volatility is low, trading volume tends to decrease due to increasingly narrow margins. In the current market, where a barrel of oil fluctuates between $29 and $31 (as seen in Figure 2 below), there are not too many investors looking to tie up huge chunks of cash for minimal gains.

As of yet, the Chinese have not rolled out their new futures contract. The down markets and slow initial growth potential are definitely two factors holding them back, but I am confident that when the INE finally unveils the platform, trading on the Chinese market will expand quickly. Like the iron-ore futures which debuted in 2013, we’ll see an explosion of interest due to the sheer size of the untapped market and China’s potential growth for oil consumption. Thirty years from now, I believe the Shanghai benchmark will rival WTI and Brent for international supremacy.